Discount retailer Target (NYSE: TGT), which operates more than 1,900 stores in the United States and Canada, has fallen more than 20% since its summer highs.
The selling has been especially pronounced since the company announced, on Jan. 10, that the massive credit card breach that occurred during the holiday shopping season was even worse than originally reported. In addition to the original 40 million people that had card numbers stolen, up to 70 million had their personal information compromised in some way.
TGT sold off more than 13%, hitting a new 52-week low of $ 54.66 on Feb. 5, before recovering slightly.
In my opinion, the breach did not warrant such a big drop. And in addition to the market’s overreaction, keep in mind that TGT was caught up in the broader market selling that hit almost all equities in the latter half of January.
On the fundamental side, TGT’s price-to-earnings (P/E) ratio of 15 is in line with the SPDR S&P 500 (NYSE: SPY), and it’s forward P/E is just over 13. Additionally, its price/sales (P/S) ratio of 0.49 is superb.
The company pays a $ 1.72 annual dividend for a current yield of 3%. But we can turbocharge the income with a covered call strategy.
A call option gives the buyer the right but not the obligation to buy shares of the underlying stock at an agreed upon price (the option’s strike price) within a certain period of time.
The seller of a call option (also known as the writer) sells the right to the buyer for a payment known as premium. In doing so, the seller assumes the obligation to deliver the shares at the agreed upon price should the buyer choose to exercise her or his right.
With TGT trading at about $ 56.95 per share at the time of this writing, we can buy 100 shares and simultaneously sell an April call option with a $ 60 strike price, which is currently trading for about $ 0.72 ($ 72 per contract) and expires on April 17. (These calls expire on the Thursday prior to the third Friday of April due to the market being closed for the Good Friday holiday.)
Since we receive $ 0.72 for selling the call, our net cost is lowered to $ 56.23 per share. To give you some wiggle room, I like this trade at a net cost of $ 56.45 or less.
Here’s how this covered call trade could work out:
If the shares stay above the $ 60 strike price, the buyer will buy the shares from us at $ 60, giving us a gain of at least $ 3.55 per share, or 6.3% in 64 days. This works out to a 36% per-year rate of return.
If TGT trades lower, we would not experience a loss unless it falls below our net cost of $ 56.45 or lower, giving us a cushion of about 1% at current levels. With TGT trading close to its 52-week low, I think the risk of a large decline is greatly reduced.
If TGT is below $ 60 at expiration, then the call option will expire worthless. We then have the ability to sell another call option against the shares to generate more income and lower our cost basis further.
The current price of the option is about 1.26% of the stock’s price. Selling an option for that amount every 64 days would generate income of about 7.2% a year. Combined with the dividend yield of 3%, the income on this position could total 10.2% a year — a 240% increase over the dividend alone.
So, using a covered call strategy allows you to generate additional income as you wait for renewed upside in this stock, and it also protects you on the downside in this volatile market.
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